Should we worry about American debt? – Part four

Summary

The debt of the federal government has mushroomed in recent years. The $27 trillion of marketable U.S. government debt at present is equivalent to roughly 100% of GDP, which is its highest ratio since the end of the Second World War.

Chronic budget deficits have led to the inexorable rise in federal government debt. Outlays have averaged about 21% of GDP over the past 50 years while revenues have averaged only 17% over that period.

Reducing the deficit is simple, at least in theory. Lawmakers simply must raise taxes, rein in spending or some combination thereof. In reality, however, reducing the deficit is very difficult. Raising taxes is a political non-starter at present, and reining in spending involves its own challenges.

The entitlement programs of Medicare, Medicaid and Social Security account for nearly one-half of federal spending at present, while defense spending and interest payments on the debt represent another 13% and 11%, respectively. Therefore, more than 70% of federal spending is essentially "untouchable" from a political perspective. Even if lawmakers completely zeroed out all non-defense discretionary spending, the federal government would still be incurring a deficit.

The good news is that a debt crisis does not appear imminent. Investors continue to finance budget deficits by buying Treasury securities at reasonable interest rates. Given the depth and liquidity of the market for U.S. Treasury securities, the status of the United States as the world's largest economy and strongest military power, and the role of the U.S. dollar in the international monetary system, there simply is no substitute for Treasury bills, notes and bonds.

But there are some costs that the rising amount of federal debt imposes. The rising debt service burden can potentially constrain other areas of federal spending, and private investment spending could potentially be "crowded out" by elevated interest rates.

The Congressional Budget Office projects that the debt-to-GDP ratio of the federal government will rise from about 100% at present to 180% in thirty years. It is an open question whether investors will feel sanguine about the fiscal outlook for the federal government indefinitely. It is impossible to determine when a "hard stop" could occur, but an ever-rising debt burden clearly increases the probability of such an event occurring at some point in the future.

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